Addressing Customer Concentration: How High is Your Risk?
While recurring revenue and EBITDA constitute the staples of a business’s value, there are other variables that are considered in the valuation equation. One important variable that often gets overlooked by business owners preparing for a sale is customer concentration. Before going to market, sellers are wise to understand their business’s level of concentration, and proactively work to lower concentration if levels could potentially be viewed as risky in the eyes of a buyer.
Why is Customer Concentration Important?
As buyers evaluate targets, part of the due diligence generally involves measuring the stability of the customer base. Typically, a company’s top 15 – 20 customers are analyzed to determine what percent of revenue they account for. High customer concentration can be a serious red flag. Buyers often associate concentration with risk because if major accounts are lost after the deal closes, the net profit can start to look drastically different. As a result, buyers regularly discount the value of a business – and subsequently offer less than the asking price – if they find that there is a high level of customer concentration. In many cases, sellers are painfully unprepared for the disconnect, or unwilling to accept the lower perceived value, making it challenging for a deal to get done.
What Amount of Concentration is Healthy?
From a buyer’s standpoint, risk is particularly high if a company generates more than 20 percent of its revenue from a single customer, or if a small handful of customers account for the majority of revenue. Since the number of customers varies from business to business, a general rule of thumb is that when the top 20 percent of customers make up more than 85 percent of revenue, you’re likely at high risk for concentration issues. Conversely, healthy concentration levels are associated with businesses that have 20 customers accounting for less than 30 percent of revenue.
How Can You Lower Customer Concentration?
If you find that your business’s customer concentration falls into the high risk category, there are methods to reduce concentration and ultimately strengthen the value of your business.
Approach Existing Customers to Evaluate Upgrading their Services
- Revisit your customer list. Are there smaller customers who have experienced recent growth and would be good candidates for increased services, or a new mix of services altogether? If your company has recently added new services, make sure all your existing customers (not just the big accounts) know about the new options and how they can add them on to their agreements.
Invest in Business Development to Nurture Existing Business and Target New Customers
- Ensure that someone at your company is regularly checking-in with existing customers. Additionally, don’t just rely on inbound leads. Allocate specific time to target new business and actively track of your new business funnel. A strong sales funnel can be another way to strengthen or increase your business’s perceived value.
Introduce a Customer Referral Program
- A well thought out referral program is a great way to generate new business. When designing the program, consider things such as the mix of channels you’ll use to communicate the message (phone, email, social media etc.), and determine the specifics of how existing customers will be incentivised.
Consider Customer Surveys or Measuring NPS (Net Promoter Score)
- Surveys or tools such as NPS measure customer satisfaction. Proving that you have satisfied customers can support the claim that you have a stable customer base, and make it harder for prospective buyers to discount due to higher concentration. What’s more, high NPS rated companies can leverage that rating to attract additional new business.
If you’re considering the eventual sale of your business, take the time to proactively address potential red flags such as high customer concentration. The upfront time invested to resolve issues will be well worth the effort when it comes time to sell your business.
Looking for more information on preparing your business for a sale? Read our resource article, How to Prepare for a Sale this Year.